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CAPITAL

BUDGETING CASE: WRITING ASSESSMENT ONE









Capital Budgeting Case: Writing Assessment One

Kaitlyn Krinock

Seton Hill University

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE



Abstract
This paper will report the findings of financially analyzing two different companies
to form a capital budgeting decision. The companies have been analyzed through
projected income statements, projected cash flows, and finding Net Present Value
and Internal Rate of Revenue from the projected statements. All of the analysis and
calculations will be provided at the end of the paper. Through the analysis, the data
shows that between Corporation A and Corporation B, Corporation B should be the
corporation acquired. Three different peer reviewed sources are used to back up the
data that has been found. Each corporation will be looked at and reported in great
detail, to provide further evidence that backs up the decision that is made to acquire
Corporation B instead of Corporation A.










CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE


Capital Budgeting Case-Writing Assessment One


The company was given $250,000 to invest in a company and acquire it. There were
two different options, Corporation A and Corporation B. In order to choose the best
corporation to acquire, a financial analysis had to be completed. The analysis
included 5 year projected income statements and cash flows. From the statements,
Net Present Value and Internal Rate of Return were determined. The decision to
invest in Corporation B comes from the results of the statements, Net Present Value,
and Internal Rate of Return. This paper will report the findings from the analysis on
both corporations and evaluate the information that leads to investing in
Corporation B. It will also look into the relationship between Net Present Value and
Internal Rate of Return and also other factors that come into play when faced with a
capital budgeting decision.
Corporation A
The information for Corporation A was provided in order to have the appropriate
details to conduct the analysis. The information for Corporation A is as follows.
Corporation A has beginning revenue of $100,000 a year that increases by 10
percent each year after that. The expenses are $20,000 a year and increases 15
percent each year. The depreciation expenses for the corporation are straight-line at
$5,000 a year, each year. The tax rate for the corporation is 25 percent with a
discount rate of 10 percent. The 5-year projected income statement was the first
piece that was completed. It shows net income for the next five years. It is calculated
by finding earnings before deprecation and taxes, which is equal to revenue minus
expenses. Depreciation expense is then subtracted from that to find earnings before

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE


taxes. After calculating taxes and subtracting them, net income is what is left over.
The net income for Corporation A increases steadily over the five years. The next
piece is Cash Flow. Cash flow starts by using Earnings Before Depreciation and
Taxes. Depreciation expense is subtracted out, to arrive at Earnings before Taxes.
After calculating taxes and subtracting it out again, depreciation expense is added
back into the earnings. This expense is added back into the cash flow because it is a
noncash expense, so it does not count against the cash flow of the corporation. The
cash flow for Corporation A steadily increases, similar to how the net income does.
After producing the two statements, Net Present Value and Internal Rate of Return
could be found. Net Present Value and Internal Rate of Return are related to each
other; the IRR that is found is the discount rate that would make Net Present Value
equal to zero. The Net Present Value is $20,979.41 and Internal Rate of Return is
13.05 percent. These values would be considered good; if this were the only option
then this would not be a bad investment to make. Net Present Value is positive,
which is the first determination that needs to be made. The standard decision for
NPV is that the project should be accepted if NPV is greater than zero and rejected if
NPV is less than 0 (Block, Hirt, & Danielson, 2014). If Net Present Value were
negative, it would be a clear sign that the investment should not be made. Internal
Rate of Return is 13.05 percent; this also verifies that this would be a good
investment. Internal Rate of Return should be a higher yield than the minimum
threshold, normally the cost of capital for the company (Block, Hirt, & Danielson,
2014). The Internal Rate of Return on this investment is 3.05 percent higher than

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE


the discount rate of the corporation, so there are no signs that this corporation
should not be invested in.
Corporation B
The information to conduct an analysis on this corporation was also provided. The
information is as follows. Revenue for the company for year 1 is $150,000 and the
revenue increases by 8% every year. Expenses for year 1 are $60,000 and increases
10% each year. Depreciation expense is the same ever year at $10,000. The tax rate
is the same as the previous corporation at 25% and the discount rate is 11%. The
income statements project that the corporations income will increase for the next
five years. The cash flow also projects that it will increase each year for the next five
years. Net Present Value of the investment, which was found after completing the
statements, is $40,275.47 and Internal Rate of Return is 16.94%. The information
known about these two numbers show these are acceptable numbers. The NPV is
above zero, which means the project should be accepted and the IRR is 5.94 above
the discount rate of 11%. Analyzing the investment option by these numbers show
that this would be an accepted investment.
Budgeting Decision
The budgeting decision that needs to be made is mutually exclusive. When one
corporation is chosen, the other one will not be (Block, Hirt, & Danielson, 2014). The
capital budgeting decision that needs to be made is between Corporation A and
Corporation B and Corporation B should be invested in. Based off of the statements
and the two different methods of ranking the options, Corporation B ranks as the
best. Looking solely at the statements, net income and cash flow are higher for this

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE


corporation for each of the five years, so this corporation will make the most money.
Going deeper and looking into the different methods, NPV and IRR both rank this
corporation superior. The Net Present Value difference between the two
corporations is $19,296.06, with Corporation B being the larger number. This shows
that Corporation B is that much greater than zero, which is the determining number
between good and bad investments. The further away from zero, the better the
investment, so NPV also backs the decision to invest in Corporation B. The Internal
Rate of Return differs 3.89% between the two corporations. Corporation As IRR is
3.05 above the discount rate, while Corporation Bs IRR is 5.94 above the discount
rate. Since Corporation Bs difference from discount rate is higher, the Internal Rate
of Return calculation also shows the Corporation B is the superior Corporation to
invest in. The previous two methods were only two of three methods discussed for
determining the rank of investment proposals. Payback method was the third, which
uses the cash flows to determine how long it will take the investment to get paid
back (Block, Hirt, & Danielson, 2014). Using this method, the $250,000 required to
invest in these corporations will be paid back in approximately 3.64 years for
Corporation A and 3.31 years for Corporation B. The payback method also supports
the investment in Corporation B.
Limitations
There is one main limitation to analyzing the data for these investments. In the real
world, a large portion of this decision would be dependent on risk. Risk is not a
factor in this capital budgeting decision. The cost of the risk that comes along with

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE


your investments is a crucial concept for a company and risk can be priced and
defined at different levels because of market imperfections (Froot, 2007).
Another limitation comes from common practices. It is not generally correct to
accept the higher NPV value (Myers, 1974). After calculating NPV, APV should be
found, which is adjusted present value. Adjusted present value is adjusted for the
projects side effects on other investment and financing options (Myers, 1974).
Although this might be done in the real world, this is not a part of the chapters or
what has been taught in class. Therefore, this is not calculated into the capital
budgeting decision.
Conclusions
In conclusion, Corporation B should be the corporation that is invested in and
acquired. The analysis that was completed and the different methods that were used
to rank the two different investment options both support the decision to acquire
Corporation B. There are different limitations that were not factored into the study
and analysis that could potentially affect the decision if they were to be factored in.
Corporation B is the corporation that should be acquired based on Net Present
Value and Internal Rate of Return.





CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE


References
Block, S. B., Hirt, G. A., & Danielson, B. R. (2014). Foundations of Financial
Management. New York, NY: McGraw-Hill Education.
Froot, K. A. (2007). Risk Management, Capital Budgeting, and Capital Structure
Policy for Insurers and Reinsurers. The Journal of Risk and Insurance, 74 (2),
273-299.
Myers, S. C. (1974). Interactions of Corporate Financing and Investment DecisionsImplications for Capital Budgeting. The Journal of Finance, 29(1), 1-25.




















Exhibits

Exhibit 1. 5-Year Projected Income Statements (Corporation A)
Year
Revenue
Expenses
Earnings Before Depr & Taxes

1
2
3
4
5
100,000.00 110,000.00 121,000.00 133,100.00 146,410.00
20,000.00 23,000.00 26,450.00 30,417.50 34,980.13
80,000.00 87,000.00 94,550.00 102,682.50 111,429.88

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE


Depreciation Expense
5,000.00
5,000.00
5,000.00
5,000.00
5,000.00
Earning Before Taxes
75,000.00 82,000.00 89,550.00 97,682.50 106,429.88
Taxes
18,750.00 20,500.00 22,387.50 24,420.63 26,607.47
Net Income
$56,250.00 $61,500.00 $67,162.50 $73,261.88 $79,822.41

Exhibit 2. 5-Year Projected Cash Flow (Corporation A)
Year
1
2
3
4
5
Earnings Before Depr & Taxes
80,000.00 87,000.00 94,550.00 102,682.50 111,429.88
Depreciation Expense
5,000.00
5,000.00
5,000.00
5,000.00
5,000.00
Earnings Before Taxes
75,000.00 82,000.00 89,550.00 97,682.50 106,429.88
Taxes
18,750.00 20,500.00 22,387.50 24,420.63 26,607.47
Earnings After Taxes
56,250.00 61,500.00 67,162.50 73,261.88 79,822.41
Depreciation Expense
5,000.00
5,000.00
5,000.00
5,000.00
5,000.00
Cash Flow
$61,250.00 $66,500.00 $72,162.50 $78,261.88 $84,822.41

Exhibit 3. NPV & IRR (Corporation A)

Net Present Value
$20,979.41
Internal Rate of Return
13.05%

Exhibit 4. 5-Year Projected Income Statement (Corporation B)

Year
1
2
Revenues
150,000.00 162,000.00
Expenses
60,000.00
66,000.00
Earnings Before Depr & Taxes
90,000.00
96,000.00
Depreciation Expense
10,000.00
10,000.00
Earnings Before Taxes
80,000.00
86,000.00
Taxes
20,000.00
21,500.00
Net Income
$60,000.00 $64,500.00

Exhibit 5. 5-Year Projected Cash Flow (Corporation B)
Year
1
2
Earning Before Depr & Taxes
90,000.00
96,000.00
Depreciation Expense
10,000.00
10,000.00
Earnings Before Taxes
80,000.00
86,000.00
Taxes
20,000.00
21,500.00
Earnings After Taxes
60,000.00
64,500.00
Depreciation Expense
10,000.00
10,000.00
Cash Flow
$70,000.00 $74,500.00

3
174,960.00
72,600.00
102,360.00
10,000.00
92,360.00
23,090.00
$69,270.00

4
188,956.80
79,860.00
109,096.80
10,000.00
99,096.80
24,774.20
$74,322.60

5
204,073.34
87,846.00
116,227.34
10,000.00
106,227.34
26,556.84
$79,670.51

3
102,360.00
10,000.00
92,360.00
23,090.00
69,270.00
10,000.00
$79,270.00

4
109,096.80
10,000.00
99,096.80
24,774.20
74,322.60
10,000.00
$84,322.60

5
116,227.34
10,000.00
106,227.34
26,556.84
79,670.51
10,000.00
$89,670.51

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE




Exhibit 6. NPV & IRR (Corporation B)
Net Present Value
$40,251.47
Internal Rate of Return
16.94%

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